What it means
Institutions are usually grouped by what they do. Depository institutions such as banks and credit unions take deposits and lend them out; contractual savings institutions such as insurers and pension funds collect premiums or contributions and invest them over long horizons; investment institutions such as fund managers and brokers pool and trade money on behalf of clients.
Many large groups do several of these at once. They matter to ordinary businesses because they set the terms on which money is available.
The rate on your overdraft, the fee on your card payments, the premium on your cover and the return on your deposits are all decided inside these organisations. Understanding how they make money makes negotiating with them considerably easier.
A bank earns its living mainly on the spread between what it pays depositors and what it charges borrowers, supplemented by fees for accounts, payments and advice. The headline measure is net interest margin, which expresses net interest income as a percentage of the assets that earn interest.
Insurers work differently, earning an underwriting result on premiums plus an investment return on the money they hold before claims are paid. The nuance worth carrying into any conversation with one is regulation and capital.
Institutions must hold capital against the risks they take, so a loan that looks fine commercially may still be declined because of how much capital it would consume. Deposit protection schemes also cap how much of your money is guaranteed if the institution fails, which is a real consideration for a company holding large balances in one place.
Size and ownership shape behaviour too, and it is worth knowing which type you are dealing with. A listed bank answers to shareholders and tends to price to a target return, whereas a credit union or mutual is owned by its members and can accept a thinner margin in exchange for service.
That difference often explains why two lenders look at the same application and reach opposite conclusions.
In practice
Real-world examples.
Example
A manufacturer with $2,400,000 sitting in one bank account discovers that deposit protection covers only a fraction of it. The finance director splits the balance across three institutions and moves the surplus into short-dated government securities.
Example
A retailer negotiating card processing fees learns that its acquirer earns roughly 0.6% of every transaction. Armed with that, it tenders the contract and cuts the rate to 0.42%, worth about $54,000 a year on $30,000,000 of card sales.
Example
A start-up is declined for a $250,000 loan by a large bank but approved by a local credit union that knows the sector. The difference is not the numbers but the institution's model and its appetite for that kind of risk.
Formula
Calculation
Net Interest Margin = (Interest Income - Interest Expense) / Average Earning Assets
A mid-sized bank reports the following for the year:
Interest income from loans and securities: $48,000,000
Interest paid to depositors and wholesale funders: $18,000,000
Average earning assets: $750,000,000
Net interest income = $48,000,000 - $18,000,000 = $30,000,000
Net interest margin = $30,000,000 / $750,000,000 = 4%
A 4% margin means the bank earns four cents of net interest for every dollar of earning assets it holds. Out of that it must cover staff, premises, technology, loan losses and its own cost of capital, which is why a shift of even half a percentage point in the margin moves profits sharply.Case study
Seen in the real world.
Ravensmoor Community Bank is a fictional institution created solely to illustrate how these businesses operate. It held $750,000,000 of earning assets and ran a net interest margin of 4%, generating $30,000,000 of net interest income.
When market rates fell, the illustrative bank found it could not cut deposit rates below zero while loan yields kept dropping, and the margin compressed to 3.4%. That reduced net interest income to $25,500,000, a fall of $4,500,000, without a single customer leaving. Costs, meanwhile, were largely fixed.
Ravensmoor responded by growing fee income from payments and advice, tightening its cost base, and lengthening the maturity of some lending. The fictional example shows why banks care so intensely about a measure most customers have never heard of.
Watch out
Common mistakes.
- Assuming all financial institutions are banks. Insurers, pension funds, brokers and payment companies are institutions too, and they are governed by different rules.
- Believing deposits are fully protected regardless of size. Protection schemes cap the guaranteed amount per depositor per institution, so large balances need spreading.
- Thinking a loan decline reflects only your numbers. Capital rules, sector limits and internal appetite often matter as much as your accounts.
Questions
People also ask.
How do banks actually make money?
Mostly on the spread between deposit and lending rates, plus fees for accounts, payments, cards and advisory services.
Are credit unions financial institutions?
Yes, they are member-owned depository institutions that take savings and make loans, typically with a community or employment link.
Why does a bank ask for so much documentation?
Anti-money-laundering and know-your-customer rules require institutions to verify who they are dealing with, and the penalties for failing are severe.
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